Who’s to Blame for India’s Inflation?

Activists protest against inflation during a rally in New Delhi in July.

There are numerous theories about the stubbornness of India’s inflation. Is it higher commodity prices, driving up costs for critical elements such as food and energy?The drought in 2009 that sent wheat and sugar prices skyrocketing? The floods during harvests in 2010 that killed much of India’s crop of onions, a key staple? Or perhaps government spending and a lax central bank is to blame?

All this takes great urgency this week with the latest monthly inflation figures due out Wednesday and the Reserve Bank of India meeting Friday to decide whether to add a twelfth interest rate increase to its year-and-a-half inflation-fighting campaign. So far, the rate increases haven’t done much good. Since the RBI started lifting rates, the economy has slowed from 9.4% to 7.7%. Yet inflation–according to the flawed, but most-closely watched Wholesale Price Index–is still running close to 10%, uncomfortably high.

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Here are three views from some smart thinkers on India’s economy:

Surjit Bhalla of New Delhi-based Oxus Investments, strips it all down to oil. He looked at data for the past 31 years and says “none of the traditional variables explains inflation in India. Money supply, fiscal deficits, GDP growth. So what does explain? International inflation,” he says. “The price of oil reflects everything.”

“Indian inflation for the last thirty years is strongly correlated to international inflation which in turn is correlated to commodity prices over which domestic monetary policy has little control.” He says the best way to fight inflation is to increase competitiveness.

Ajay Shah, economist for the National Institute for Public Finance and Policy says the blame is much more homegrown, and points the finger at government actions, especially lax monetary policy. He had this to say in a WSJ article Monday:

“There’s an excuse, ‘Oh, we have a bad harvest’ or ‘Oh, there’s been a global commodities price shock’ or ‘Oh, it’s just the fault of the crude oil.’ I think that’s a big mistake. This has been a persistent problem and it reflects a failure of macro policy,” Mr. Shah said. Inflation has been above the government’s informal target since 2006, he said, long before food prices jumped.

He blames the RBI for “muddying the waters” on its communications strategy, hiking rates one day and then saying in speeches that rate increases have little effect on things like food prices. That sends the wrong signal and lets inflation get embedded in the minds of consumers and business owners.

“An integral part of inflation control is communication,” he says. “You have to change the minds of households and firms. That’s half the battle. It’s human beings who make inflation.”

Saumitra Chaudhuri, an economic advisor to the prime minister and member of India’s influential Planning Commission, agrees that psychology is a big part of it. Indians have become accustomed to ever-rising prices and don’t trust the government to tackle the problem. You can see that in the very high inflation expectations Indian households have (see chart).

For instance when onion prices skyrocketed in 2010, so did everything else, he says. “Not only onion prices go up. Cooking oil prices went up and every bloody year vegetable prices went up. Why did they go up? Because everybody said the government isn’t in control, come on let’s make money.” He does lay some of the blame on international commodity prices.

But he also sees some unintended consequences of well-intentioned government social programs, widely considered a great success in educating India’s rural poor. The school participation rate for rural children in India has risen to 96.5% from 93.4% in 2005, according to the Indian non-governmental education organization Pratham. But it’s had the effect of removing labor supply (illegal or otherwise) and driving wages higher.

“If they are in schools, they are not in the labor force. One source of low-cost labor isn’t there,” Mr. Chaudhuri says.

Another example: The government’s landmark Mahatma Gandhi National Rural Employment Guarantee Act, a massive jobs program rolled out to millions of poor. It has put cash in the hands of the poor, but the program has also failed, largely because of corruption and incompetence, to deliver on the promised productivity increases, such as better roads and irrigation that should have boosted agricultural productivity, helping stem food inflation.

The effect of the rural jobs program has rippled across India’s labor markets, where less people are migrating from the countryside seeking factory work. The program “created some kind of assurance of employment in rural India, which improves the bargaining power of agricultural labor and led therefore to a rise in wages,” he says.

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